Tracing the Distributional Effect of Trade Policy on Firm Value
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Tracing the Distributional Effect of Trade Policy on Firm Value∗ Yahui Wang† This Version: December 2019 Abstract I investigate the effect of trade liberalization policy on firm value. I identify this effect by exploiting cross-sectional differences in firms’ exposure to potential tariff hikes imposed on U.S. imported goods from China. I examine both U.S. and Chinese equity market responses when U.S. granted permanent normal trade relations (PNTR) to China in 2000, and document puzzling responses from the Chinese market: Firms with larger downside risks that were eliminated—and thus were likely to gain more access to the U.S. market—suffered larger equity value reduction when the PNTR bill passed. I discover that the negative stock market reactions are driven mainly by state-owned enterprises (SOEs). I then propose a mechanism in which SOEs and non-SOEs differ in their capacity to withstand negative shocks due to government’s safety net provision. The proposed mechanism is supported by evidence from firm exporting activities and stock market responses during anti-dumping episodes. My results imply that trade policy uncertainty elimination may generate distributional gains from reallocation to more efficient firms in the context of inefficient institutions. ∗I am indebted to my advisor, Kent Daniel, for his advice and support throughout this project. I am grateful to Jesse Schreger and Olivier Darmouni for their generous encouragement and instructions. I thank the participants in the Finance Seminar and PhD Student Seminar at Columbia Business School and the Financial Economics Colloquium at Columbia University. Any errors are my own. †Columbia Business School. Email: [email protected]. 1 1 Introduction The past two decades have witnessed China’s integration into the global trade market, which has been one of the most influential economic developments that shape today’s eco- nomic landscape around the world. China’s global power has grown considerably in recent years. It is now the world’s second largest economy by nominal GDP and the largest man- ufacturing economy and exporter of goods. For instance, the U.S.’s share of imports from China rose from 7% to 22% between 1997 and 2017.1 This paper investigates a major trade liberalization event—the U.S. granting permanent normal trade relations (PNTR) to China, which has drastically changed U.S.-China trade relations since 2000—and sheds light on how trade policy affects firms’ performance. I use an event study approach to capture changes in firms’ value from a capital market perspective and examine firms’ exporting activities to uncover the mechanism that explains their equity market responses to the policy shock. I confirm the results of Greenland et al.(2018), that U.S. firms experience greater market value reduction if they are more exposed to potential import competition from China.2 Surprisingly, I find that Chinese firms exhibit similar equity market responses in the cross- section: Chinese firms potentially gaining more access to the U.S. market seemed to suffer larger market value loss when the PNTR bill was passed. How could this U.S.-China trade liberalization event be a worse shock for Chinese firms supposedly gaining more market share in the U.S.? A closer look at the Chinese market reveals that the results of larger market value re- duction with respect to higher degrees of U.S. market penetration are driven mainly by Chinese state-owned enterprises (SOEs). I propose a mechanism that features market share redistribution in response to foreign trade policy shocks to explain the puzzling Chinese eq- uity market responses. SOEs enjoy safety net provisions from the government and were less sensitive to potential trade barrier increases before PNTR, and thus benefit less from the reduced trade cost induced by this trade liberalization. On the other hand, PNTR grants the entry of more Chinese non-SOEs into U.S. markets, driving down the profits of SOEs. The competition effect overshadows the benefit from reduced trade costs for Chinese SOEs, and contributes to the negative equity market responses. This is the first paper, to the best of my knowledge, that documents Chinese firms’ equity 1Source: United Nations Statistics Division (UNSD) 2I follow Pierce and Schott(2016) and quantify potential increases in import competition after the PNTR event via the “NTR gap,” defined as the difference between non-NTR tariff rates and NTR tariff rates. 2 market performance around the PNTR event. The U.S. granting PNTR to China in October 2000 is a much-studied policy change in the international trade literature, yet few papers explore the capital market consequences of this U.S.-China trade liberalization. This paper fills the gap. It also provides first evidence on how the Chinese equity market reacts to the PNTR shock, and further rationalizes the findings in the context of insufficient institutions. I adopt an event study approach and look at stock market reactions around the PNTR event. The benefit of using equity market performance is that it captures the expected net influence on firms (and industries). Trade policy changes not only affect current economic outcomes, but also shape investors’ expectations on future cash flows and discount rates, which are reflected in the stock prices. In an informational efficient market, the stock price movements reflect the market implied overall impact of the trade policy shock on firms’ cost of capital. The event study approach, on the other hand, is justified because there was considerable doubt regarding passage of the China Trade bill granting permanent NTR status to China. The legislation received Republican support, but the Democrats voted against it.3 It took the combination of a Republican Congress and a Democratic president to successfully pass the bill.4 The conferral of PNTR in 2000 eliminates the threat of tariff increases being imposed on U.S. imports from China. Before this policy shock, normal trade relations (NTR)5 status for China was temporarily granted and required annual renewal by the U.S. Congress, beginning in 1980. Had China’s NTR status been revoked, U.S. import tariffs on Chinese goods would have jumped to a much higher set of non-NTR tariff rates6, which were established under the Smoot-Hawley Tariff Act of 1930. I define “NTR gap” as the difference between the higher non-NTR and the lower NTR tariff rate, following Pierce and Schott(2016), for all U.S.-China bilaterally traded goods for which both sets of tariff rates are available. I then aggregate the product-level tariff spreads to compute firm-level NTR gaps to quantify the degree of potential import competition for U.S. firms (and, equivalently, U.S. market access 3Detailed voting records can be accessed at https://www.govtrack.us/congress/votes/106-2000/ h228. 4In the last year of his presidency, Bill Clinton called on Congress to help improve trade relations with China. 5Normal trade relations (NTR) is a U.S. term for the familiar principle of most favored nation (MFN). MFN is a status or level of treatment accorded by one state to another in international trade. The members of the World Trade Organization (WTO) agree to accord MFN status to each other. Since 1998, the term “normal trade relations” (NTR) has replaced most favored nation (MFN) in all U.S. statutes. 6In 2000, the average MFN tariff rate was less than 5%, while the average non-NTR tariff rate was around 30%. 3 for Chinese firms). Within the framework of the event study, I investigate firms’ equity returns across 2 days before and after five key legislative milestones.7 I find that, over the 25 days within the voting event windows, a one standard deviation increase, 14%, in the NTR gap corresponds to approximately a 5.2% (2.4%) decrease in market value, or about 160 million USD (93 million CNY, or 11 million USD8) loss for shareholders in the U.S. (Chinese) equity market. After documenting firms’ stock returns in response to the PNTR policy shock for both U.S. and Chinese markets, I further explore how abnormal returns could carry negative loading on the scale of freed-up U.S. market access for Chinese firms. I find that the surprising negative responses are mainly driven by Chinese SOEs. The PNTR bill has distributional effects, and hurts certain types of Chinese firms. Namely, for Chinese firms operating in an industry (A) that has one standard deviation more exposure to the U.S. market than another industry (B), the magnitude of underperformance by SOEs versus non-SOEs is approximately 6% more—roughly 216 million CNY (or 26 million USD)—in industry A than in industry B. I then propose a mechanism to rationalize the distributional effects observed in the Chi- nese market. I model firms’ differential sensitivity to negative policy shocks within a simpli- fied Melitz(2003) framework of heterogeneous firms. Simulations demonstrate that Chinese firms’ profits decrease in larger NTR-tariff-gap industries, but only for SOEs, which is con- sistent with the equity market evidence. The model also predicts contrasting exporting behaviors for Chinese SOEs and non-SOEs. Using administrative-level Chinese customs data, I provide empirical support for the proposed mechanism. Consistent with the model, I find faster growth in the number of exporters and a larger increase in the value of exported goods in larger NTR-gap industries, but only for non-SOEs. SOEs, on the other hand, cut down exporting activity on both the intensive and extensive margin in larger NTR-gap industries. It is worth pointing out that the majority of the empirical results explore the NTR gap distribution in the cross-section. The fact that about 80% of NTR gap variation comes from non-NTR tariff rates, which were established under the Smoot-Hawley Act in 1930, renders it more likely that NTR gaps are exogenous to the economic conditions in the 21st century.